UBS: Core beliefs

Amidst all the concerns about US growth and the risks from deflation, something rather surprising has been happening: core inflation in the US has been accelerating, and accelerating quite rapidly. This matters a lot. The Fed has a dual mandate, covering unemployment and inflation. This is a very different mandate from targeting growth and oil prices, yet the market seems to be behaving as if this is what the Fed mandate actually was.

Just to confuse everyone, there are two widely-used measures of core inflation in the US: one from the consumer price index (CPI) and one which is the deflator for personal consumption expenditures (PCE). The CPI is very familiar across countries, and core is calculated simply by removing the volatile energy and food components. The PCE deflator differs in a number of ways, but most importantly it takes into account month-to-month substitution effects as consumers buy less of products that have gone up in price. The differences mean that there is often a wedge between the two, with CPI core often being higher than PCE core.

The Fed prefers the PCE core measure, but at the moment it barely matters which you choose. Both have spiked up in recent months (chart 1). Some people might complain that stripping out food and energy is removing too many of the necessities of life. These components are removed because of their volatility (which is linked to their being necessities), but there are also other measures of underlying inflation that point the same way. The trimmed-mean PCE and CPI measures remove the most volatile elements (the top and bottom 8% of moves) whether that is food and energy or something else. The median CPI measures the movement of the price that is right in the middle of the distribution. These alternative measures all show an upward trend in underlying inflation as well.

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